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Good Debt, Bad Debt

On our Investing Beginners discussion board last year, a Fool Community member asked a good question that sparked an enlightening conversation.

Awmontville said:

I'm probably not the first person to ask this question, but I would like to know what people think is good debt and what is bad debt. Specifically (and avoiding the obvious high-interest problems, e.g. credit cards), I'd like to know what you all think about school loans, automobile loans, and, of course, mortgages. My wife and I are on track to start investing in the near-term, but we want to ensure that we've made the right choices with respect to carrying certain kinds of debt while we invest.

Permit me to share some of the responses, along with a little commentary of my own.

Onparole offered his "skinny": "Debt is good when: 1) it is lower interest [than] what you are earning elsewhere and 2) the debt is tax deductible (school loans, mortgage)."

Foolazis elaborated:

Student loans: good debt. Education increases your earning potential, and usually has provisions for deferment in the event of extreme financial circumstances.

Auto loans: bad debt. Depreciating asset.

Mortgage: good debt. Appreciating asset.

All other loans: bad debt. Period.

Jbking offered this:

I think I'd summarize good debt as where you have an investment that will be worth something, e.g. school loans if you complete the program and mortgages where you'd own a property. Bad debt is where you have the debt because you bought depreciating assets, e.g. car loans, credit cards. Then there is leverage like buying on margin which can be good or bad depending on how you use it and whether or not margin calls mess things up.

He added: "There are, of course, potential exceptions as if you got a car loan with 0% interest or some other really, really low rate then this isn't necessarily so bad. Similarly, if you were paying a high interest rate on school loans or a mortgage this may not be so good."

He then offered a clarification that I was going to chime in with myself: "Last but not least, there may be a reason to take on some bad debt at times: Building a credit history. This can be useful in securing lower rates on some types of loans like mortgages and credit cards." This can be kind of critical. If you proudly go through life with no debt ever, if the day comes when you want to borrow a significant sum (such as for a house), you'll run into trouble. Lenders won't know how to evaluate you, if you have no credit history, so you might not be offered the best available rates.

Meanwhile, the conversation continued. Jrr7 added this useful detail: "Mortgages can be very bad debt if the payment is scheduled to increase in the future." That's an excellent point. Not all mortgages are created equal -- especially these days. Read up on dangerous borrowing before you sign up for an interest-only mortgage or some other extreme financial instrument.

Pirategraham opined that "there are only three things that you should ever go into debt for": getting an education, starting a business, and buying a house. He also added: "If you buy a new car, keep it for at least 10 years. If you buy a used car, keep it for at least five years."

What to doSo now, perhaps armed with a new perspective on debt (or perhaps with your previous perspective simply reinforced), what should you do? Well, think twice before taking on any debt. Assess how well it will really serve you.

And look at the big picture, too. You might rationalize that: So what? A big loan for a nice new car is worthwhile because you'll really enjoy that new car. But remember your alternatives. Instead of plunking $20,000 or $30,000 or more into a new car that will lose value over time, you might keep driving your trusty 2002 set of wheels and invest that money instead. You don't even have to knock yourself out to find good places to invest.

I myself am finding plenty of exciting mutual funds via our Champion Funds newsletter (I've invested in a handful I found there). The fund that our expert Shannon Zimmerman recommended in our November issue has beaten the market by about five percentage points, on average, over the past five years. It's a large-cap value-oriented fund, with top holdings including Wendy's (NYSE: WEN) , Marathon Oil (NYSE: MRO) , and Schering-Plough (NYSE: SGP) . A small-cap value-oriented fund he recommended just two months earlier is already up some 11%, and sports a five-year average return of 16.5%, nearly 10% more than the market average. Its top holdings include Bio-Rad Labs (AMEX: BIO) , Banta (NYSE: BN) , and Rofin-Sinar (Nasdaq: RSTI) . Take advantage of a free trial of the newsletter and you'll be able to access all past issues and recommendations.

And maybe that new car will start looking less appealing.

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Comments from our Foolish Readers

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I didn't know the difference between good debt and bad debt. It makes sense to go into debt sometimes, if that debt is going to better your situation down the road. I feel like student loans are a necessary evil but they can help you build credit. I need somebody to take a look at my finances and see if I'm on track or not. http://www.williamcfithianatty.com

Sending report...

Selena Maranjian has been writing for the Fool since 1996 and covers basic investing and personal finance topics. She also prepares the Fool's syndicated newspaper column and has written or co-written a number of Fool books. For more financial and non-financial fare (as well as silly things), follow her on Twitter... Follow @SelenaMaranjian